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Barron's MFQ

True Believers

By

Louis Lowenstein

Updated Oct. 11, 2004 12:01 a.m. ET

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FOR DECADES, ECONOMISTS HAVE MAINTAINED that smart investors make markets "honest," by keeping quoted prices in close touch with underlying values. But if that is so, where were all the smart folks in the boom, bust and recovery of 1999 through 2003, during which there often was a chasm between the prices of stocks and their intrinsic values? Did smart investors -- who for our purposes here will be defined as value investors -- experience the same giant gains and crushing losses as so many others? Did they stick to their investment philosophies throughout? Surprisingly, scholars don't know. One recent academic paper concluded that economists "have been generally unable to identify any reliably 'smart' investors." Gosh, perhaps they've been hiding.

To bring some smart money into public view, I asked Bob Goldfarb, the highly regarded chief of the Sequoia Fund, to name 10 "true-blue" value investors -- pros whom he believes comb the market relentlessly for shares trading well below their real, or "intrinsic," worth. I wanted value investors who didn't just talk the talk but walked the walk. Goldfarb came up with an outstanding list of 10, all of them mutual funds:
Clipper Fund,
FPA Capital,
First Eagle Global,
Mutual Beacon,
Oak Value,
Oakmark Select,
Longleaf Partners,
Legg Mason Value,
Source Capital
(a closed-end) and Tweedy Browne American Value. I would have included Sequoia, but Goldfarb's 10 is Goldfarb's 10.

After examining the group closely, some telling patterns emerged. The 10 funds resisted the speculative frenzy of the 'Nineties, weathered the bust and profited handsomely during the subsequent recovery. That is, they stuck to their guns. And as a result, while their performances lagged during the boom, they posted far better returns than the market as a whole over the entire five-year period.

The reason such investors didn't keep the market under control, as the so-called efficient market theory would have suggested, is that there simply aren't enough of them. Despite the fame of value investing's biggest star, Warren Buffett, the money managers genuinely adhering to this strategy probably oversee just 5% of all professionally managed money. Thus, value investors aren't remotely up to the task of keeping the market quotes of $10 trillion-plus of stocks in line with their true values.

My first test for the 10 funds was quite simple: I looked to see if they were holding any of 10 "New Economy" stocks that were getting prominent play in the media in 2000, when the market peaked. The stocks, including
Broadcom,
Enron,
Nortel Networks,Oracle
and
Viacom,
had a combined market capitalization of more than $1 trillion back then.

The 10 funds, then managing a combined $20 billion, had all given these stocks a wide berth, with two interesting exceptions. Legg Mason Value owned
Nokia,
though the stock represented less than 2% of its portfolio when purchased in 1996. Since the stock was sold in mid-2000 at a gain of 1,900%, it's hard to be too critical. And Mutual Beacon had short positions in Viacom and Nortel, meaning it had bet against the stocks. That's it. Didn't everyone own Enron back then? Sure. But not these guys.

The funds have generally cited two reasons for avoiding New Economy stocks: faulty disclosure and excessively high prices, relative to earnings and other measures of value. But during the boom, funds had a hard time sticking to the value-investing approach. As the year 2000 opened -- the bubble didn't peak until March -- most of the funds were acknowledging to their shareholders that they were sorely out of step; on average, the group had significantly underperformed the market in 1999. Given how quickly investors cash out of cold funds and jump into hot ones, to trail the pack even temporarily is a serious offense, known in the trade as a "tracking error." The Clipper Fund's annual report for 2003, facetiously described tracking errors as "professional misconduct vaguely comparable to dealing drugs."

Even as the tracking errors persisted, the fund managers in the group of 10 were vigorously reaffirming their investment principles. Envy of the crowd never caused them to lower their standards, and with money pouring into some of their rivals that must have been difficult. In its report for 1999, Mutual Beacon said it stuck "to our longstanding value and special situation approach... [We] bought only when we saw substantial upside with relatively little risk. In our opinion, risk still matters."

Soon, the value investors started to spot opportunities among Old Economy stocks. The two presidents at First Eagle Global, sounding like a latter-day Graham and Dodd, wrote in March 2000: "For five years now, and particularly [the six months to mid-March 2000], smaller and medium-sized 'value' stocks have been neglected, ignored and-in our opinion-mispriced by investors... throughout the world."

Longleaf Partners offered a similar view to its investors. The firm's lackluster, 2.18% gain for 1999 "should not overshadow the fact that 1999 was one of our best years from a buying perspective," the firm wrote. "History has proven that over time stock prices, although volatile in the short term, will converge with intrinsic business value."

Or as FPA Capital put it, "We strongly believe that the value style of investing is not dead, [merely] in a state of hibernation."

The funds knew their model, and they were staying with it. And they were soon to be vindicated. The years 1999-2003, one of the most volatile periods in market history, make a fine test. Even after bottoming in 2002 and rebounding substantially in 2003, the S&P 500 showed an average annual loss of 0.57%. If the stock market were the random walk described by academics, one would expect about a 50-50 outcome for our funds, with perhaps five performing better than the index and five worse.

But I found some things that pure chance can't explain. Over the five-year stretch, the 10 funds as a group returned, on average, 10.8% annually, or 11 percentage points per year more than the S&P. And each beat the index by a significant margin. In alphabetical order, Clipper was up, on average, 11.9% annually; FPA Capital, 15.29%; First Eagle Global, 17.02%; Legg Mason Value, 4.43%; Longleaf Partners, 10.94%; Mutual Beacon, 10.28%; Oak Value, 2.63%; Oakmark Select, 15.43%; Source Capital, 15.22%; Tweedy Brown American, 4.87%.

Value funds are likely to outpace the index when the market is falling or treading water; the "tracking error" arises primarily in the years when stocks soar. The Clipper Fund, for example, lost 2% in 1999, while the S&P 500 rose 21%. Not surprisingly, Clipper suffered big redemptions. In a prescient moment, James Gipson, the fund's senior manager, quoted John K. Galbraith's observation of the 1929 market peak: "The end was at hand but not in sight."

So, what's the secret of success? The 10 funds share a few important attributes, starting with the relatively small number of stocks they hold.

While the average domestic equity fund owns about 160 stocks, the funds in our group held an average of 54 stocks at the end of 2003. And seven of them had 34 stocks or fewer. Contrary to the advice of financial economists, investment advisers and stock-market writers, value funds believe that safety lies in careful selection, not in random diversification.

The 10 funds also hold onto their stocks for much longer than the industry norm. According to Morningstar, the average domestic equity fund had a turnover rate of 121% in 2003, equivalent to an average holding period of 10 months. Our group, however, had an average turnover of 20% that year, meaning they held their stocks for an average of five years.

Those numbers speak volumes. The difference between taking momentary fliers and selecting long-term buys is the difference, truly, between speculation and investing.

Finally, a number of managers in the group invest their own money in their funds. Obviously, this aligns their personal interests with those of their investors. The importance of this has been reinforced as the pervasive market-timing, late-trading and other abuses at some mutual funds have come to light. Managers who have their own money at risk invariably run their funds with the acute interest in profit and the extreme aversion to loss that only someone with skin in the game will experience.

Several managers in our group have passed a further test of fiduciary duty, having closed their funds to new investors (and thus surrendered lucrative management fees), rather than dilute the results for those already there. FPA Capital, Longleaf Partners and Oakmark Select are closed now. And First Eagle Global, which has closed in the past but is now open, recently shut its sister foreign fund. The problem with a fund getting big is that it shrinks the number of companies with market capitalizations large enough to permit the fund to amass a significant position. It's not how much money you manage, but rather how you succeed with what's there.

While all 10 funds embrace the value philosophy, they apply it in quite different ways. Some focus on small and mid-cap stocks; others on large-caps. One follows a highly quantitative approach; price-to-book value, working capital, earnings, cash flow and revenues all are primary factors in determining value. Several look for value overseas, as well as in the U.S. Another focuses on deep-discount debt and carries out risk arbitrage. There are thus many roads to heaven -- or certainly more than the low price-earnings ratios that many economists simplistically equate with value investing.

We can now start to see why the efficient-market theory doesn't quite hold up. That is, we can see why our group and other value investors are unable to keep the rest of the market honest. Not only do value investors account for a small part of the market, but there are some almost perverse factors keeping them small. When value investing is in vogue, they are tempted to close their funds. And when they are out of step with the prevailing mood, as in the late 1990s, they seem content to see their pool of assets shrink.

Furthermore, when stocks are priced high, value mutual funds, unlike hedge funds, rarely sell short. Instead, many sit on their hands, holding a bundle of cash. But even when stocks are priced low, value investors like those in our group tend to be picky. Think of Ted Williams waiting for a pitch he can hit on the sweet spot.

Ultimately, the problem is the snail's pace of trading shown by our group -- only about one-sixth that of the average mutual fund. What the efficient-market theory requires is red-blooded, rapid-fire traders, and these patient investors operate at an altogether different tempo.

For the investing public, the lesson is clear: There is no escape from the need to think hard. Over time, good money managers will beat the market, even if they don't cure the market's ills.

Investors needn't tolerate the other advisers -- the ones who try to look useful by rotating their clients' money from here to there on one day, and then from there to here on the next...to God knows where. Listen, it's your money.

LOUIS LOWENSTEIN is a professor emeritus of finance and law at Columbia University.

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